Inflationary Gap Vs Deflationary Gap
At full employment level, the equilibrium level of an economy is defined, in which the level of demand is equivalent to the level of income. When the aggregate demand is in excess of the productive potential of the economy, the gap is said to be inflationary, whereas the variance between full employment and the actual level of output, then that variance is said to be a deflationary gap.
Inflationary gap is a macroeconomic term which gauges the variance amidst the actual aggregate demand for output, i.e. real gross domestic product and the output level that would prevail if the economy is operating at full employment, i.e potential GDP. It is when the actual aggregate demand is greater in comparison to the potential aggregate demand required.
The variance is termed as inflationary gap because it triggers those factors which can cause inflation or shoots up the general price level, without increasing the level of output.
Deflationary Gap indicates the variance amidst actual aggregate demand for output in an economy, i.e. Real GDP and the maximum potential level of aggregate demand needed to set up full employment. It occurs when the actual aggregate demand is lower than the aggregate demand required.
We call the gap as the deflationary gap because it drives those factors which gives rise to deflation in the economy, i.e. fall in the general price level.
What is Deficient demand?
When the aggregate demand is for an income level, less as compared to the full employment level, so the situation of deficient demand prevails, which results in a deflationary gap.
What is Excess demand?
When the aggregate demand is for an income level, more as compared to the full employment level, the situation of excess demand prevails, which causes the inflationary gap.
What is Full employment?
Full employment implies a state when aggregate demand is equal to aggregate supply. And the people who are able and willing to work, are getting the employment, at the existing rate of wage.
What are the measures to correct excess or deficient demand?
There are several measures which can be adopted by the government with an intent to correct the excess or deficient demand, these are:
- Change in government spending.
- Change in taxes.
- Regulate the availability of credit by changing monetary policies.
- Change in the rate of interest, i.e. CRR, SLR, Bank Rate, Repo Rate, Reverse Repo Rate, etc.
Difference Between Inflationary and Deflationary Gap
The difference between the inflationary gap and the deflationary gap can be understood easily with the help of the points given below:
- At full employment level, if the aggregate demand surpasses aggregate supply, then the difference between the two is termed an inflationary gap. As against, at full employment level, if the aggregate demand is lesser in comparison to aggregate supply, then the difference between the two is called a deflationary gap.
- The demand causing inflationary gap is called excess demand, whereas the demand which results in a deflationary gap is deficient demand.
- Inflationary gap is caused due to the factors such as Rise in the propensity to consume resulting in the increase in the consumption of the households, rise in government expenditure, increase in export demand, rise in credit facilities leading to the increase in the demand for private investment, increase in disposable income, increase in investment.
The determinants behind deflationary gap are: fall in the propensity to consume, resulting in the decrease in the consumption of the households, fall in government expenditure, decrease in export demand due to global recession, fall in credit facilities leading to decrease in the demand for private investment, decrease in disposable income, decrease in investment due to financial crisis or banking collapse.
- In the case of the inflationary gap the general price level increases, but the same will decrease in the deflationary gap.
- When there is an inflationary gap the level of output is constant, whereas there is a low level of output in case of a deflationary gap.
- Deflationary gap results in the reduction in the level of investment, which may result in involuntary unemployment, because of the decrease in planned output. As against, in case of the inflationary gap, there is no effect on employment.
- As a corrective measure, the government can take resort to expansionary fiscal policy to overcome the deflationary gap, whereas to cope with an inflationary gap, contractionary fiscal policy can be used by the Government.
Quick Comparison: Inflationary Vs Deflationary Gap
|Basis||Inflationary Gap||Deflationary Gap|
|Concept||Inflationary Gap reflects the excess of aggregate demand, than the level of demand required to enable full employment equilibrium, in the country's economy.||Deflationary Gap indicates the shortage of aggregate demand than the level of demand required to enable full employment equilibrium in the country's economy.|
|Occurs when||AD > AS||AD < AS|
|Demand||Excess demand||Deficient demand|
|Causes||Rise in the propensity to consume resulting in the increase in the consumption of the households.||Fall in the propensity to consume, resulting in a decrease in the consumption of the households.|
|Rise in government expenditure.||Fall in government expenditure.|
|Increase in export demand.||Decrease in export demand, due to the global recession.|
|Rise in credit facilities leading to an increase in the demand for private investment.||Fall in credit facilities, leading to a decrease in the demand for private investment.|
|Increase in disposable income||The decrease in disposable income.|
|Increase in investment.||Decrease in investment due to financial crisis or banking collapse.
|Effect on General Price level||Due to excess demand, the general price level tends to rise.||Due to deficient demand, the general price level tends to fall.|
|Effect on Output||Constant||Low level of output|
|Effect on Employment||No effect on the employment level.||Reduction in the level of investment, leading to involuntary unemployment, because of the decrease in planned output.|
|Measure to Improve||Contractionary Fiscal Policy||Expansionary Fiscal Policy|
As a result of a deflationary gap, the economy’s resources are not utilized in full and they remain idle which causes unemployment and the output level is low.
Further, in the inflationary gap, the economy operates at a level over and above the full employment level. And because of the shortcoming of the economy to fulfil the increased demand, the average price level in the economy rises, which causes inflation.